Roger Mortimer's search for value in an overpriced equity market

The CI Harbour manager has avoided high-flying growth stocks, and his relative performance has suffered.

Michael Ryval 25 October, 2018 | 5:00PM
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By several measures, much of the U.S. equity market is overpriced, argues Roger Mortimer, senior vice-president at Harbour Advisors, a unit of Toronto-based CI Investments. And with a prime focus of preserving unitholders' capital, Mortimer firmly believes that value stocks are a safer bet in these uncertain times.

"I am an active manager, which means that the investment portfolios that I manage do not look like the indices at all," says Mortimer, lead manager of the $349.3-million CI Harbour Global Growth & Income Corporate Class. "The consequence of being an active manager is that by definition your results are very different from the index. Sometimes you are better than the index, and sometimes the index does better than you."

There's no doubt that of late the fund has underperformed, Mortimer admits. In the year-to-date, it has lagged the Global Equity Balanced category by about 7 percentage points as of Oct. 22. However, on a five-year basis, the two-star rated fund narrowed the performance gap because it had an annualized 5.7% return, or 0.44 percentage points below the category median.

In his own defence, Mortimer argues that the last six months have been especially challenging. "An active manager's dispersion from the index can come from two sources: things that you did own that did not work, or things that you didn't own and did work," says Mortimer, a Toronto native and 32-year industry veteran who joined Harbour Advisors in October 2013 after working for firms such as Los Angeles-based Capital Group Companies. "What's occurred this year in the overall investing environment is a change in the macroeconomic environment that has had a significant impact on investment outcomes in different markets."

Mortimer pinpoints the change in the market to late March when investor sentiment changed. A year ago, the investment world was abuzz with the global synchronized recovery that saw global economies growing at a healthy rate. "For the first time in 50 years, every nation in the OECD [Organization for Economic Co-operation and Development] was experiencing growth," recalls Mortimer, adding that major indices moved more or less in tandem. "You had an environment in which sentiment was positive and you could be a stock-picker and make investments in the OECD and the company-specific factors would be the differentiator. But something changed earlier this year."

Mortimer points to the Trump administration in the U.S. adopting aggressive tactics on global trade. "The global trade environment went from collaborative to hostile," observes Mortimer, who also manages the $2.7-billion CI Harbour Growth & Income, a tactical balanced fund. The U.S. economy is largely self-contained, which means external trade, as a portion of its total economy, is significantly less than in many other countries. "The effect of that is when you are the biggest customer and pick a fight with five other nations, for whom trade is more significant than it is for you, everybody else suffers. The U.S. created an environment in which the future terms of trade were uncertain. So investment decisions get deferred in other countries. This has cast a shadow over all of the U.S.'s trading partners."

It has shown up in key indices. For instance, the benchmark S&P 500 Index has climbed about 15% year-over-year. The MSCI All Country World Index is up 6.7% in the same period, But the MSCI All Country World Index ex-U.S. is down about 3%. "Money flows and valuations and investment outcomes have diverged significantly since earlier this year as investors have attempted to calibrate the impact of trade."

The dispersion is reflected in the wide gap between growth and value stocks. "The U.S. market has been led by a certain characteristic. Growth versus value has gone vertical this year and is now at an 18-year high," says Mortimer. "The top three stocks in the S&P 500 are larger [by market capitalization] than the bottom 250."

The other outcome is that expensive stocks, such as (AMZN), have become even pricier. One measure of that is the S&P 500 Shiller Price-Earnings Ratio. Currently, stocks are trading at 33.1 times earnings on a cyclically adjusted basis. The last time the ratio peaked at such a level was late 1999 when it hit 44.2 times earnings.

"We look at the facts and consider potential outcomes. Our investment style is fundamentally predicated on capital protection," says Mortimer, who is very reluctant to make any market forecasts. "We've been in a period where a certain group of expensive stocks have become more expensive. Everything else is not. We have not been part of that."

A value-oriented manager, Mortimer has split the equity side of the portfolio into three tranches (there is also about 20% in investment-grade bonds and 16% cash). The first tranche, which accounts for 22% of the fund, is comprised of mature companies that pay out much of their cash flow in dividends. The second tranche, 29% of the fund, is made up of growing companies that pay a dividend but also reinvest some capital in their business. The last tranche, about 11% of the fund, consists of growing companies that pay no dividends because they reinvest all excess cash.

Representative of the first category is  International Business Machines (IBM). "In a world where Google and others have grown rapidly in the cloud, IBM, which is regarded as an 'old-fashioned' business, is perceived as not having the tools to compete in the modern environment."

IBM, whose service business is growing in contrast to its declining manufacturing side, generates US$12 billion in free cash flow and pays a 4.3% dividend. It is also trading at 10.5 times earnings. "It is so cheap that I cannot ignore it. I would describe its situation as no longer deteriorating," says Mortimer, adding that a pick-up in the service side could push the p/e multiple to 12 times in the next year or so.

In the second category, Mortimer likes Sony. The Japanese consumer electronics firm has become more diversified from its original television manufacturing base. "Sony has been in a continuous state of restructuring. In the last few years, though, it's showing signs of true improvement," says Mortimer, noting that Sony has largely exited businesses that were capital intensive and concentrated on those that required much less capital. Those include the gaming business via its Playstation console division; music distribution through content providers such as Spotify Technology SA; and providing image sensors for smart telephones.

"The company is in the midst of a transformation," says Mortimer, adding that the stock is trading at 15 times forward earnings. "We expect Sony to grow its profitability in these three areas. We believe the earnings and valuation will increase over time."

Going forward, Mortimer concedes that he is out of sync with the rest of the market. "These money-flow factors have contributed to a very narrow group of stocks leading the marketplace," observes Mortimer. "Do I think they will continue to lead forever? No, I don't. Occasionally, we will have periods of being out of step. That is the nature of being an active manager."

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Michael Ryval

Michael Ryval  Michael Ryval, a regular contributor to Morningstar, is a Toronto-based freelance writer who specializes in business and investing.

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